Earn-out

When a company is sold, the buyer and seller have to agree on a price. Often their expectations are far apart. The seller says: My business is growing strongly, it’s worth 100 million. The buyer says: That still has to prove itself, I’ll pay 60 million. An earn-out resolves this dispute with a compromise. The buyer pays a base amount immediately, say 60 million. He pays the rest later – but only if the company actually performs as well over the next few years as the seller claimed.

A price dispute postponed to later

The value of a company depends above all on its future. And that is precisely what nobody knows. This is especially difficult with young technology companies. A start-up with 30 employees and a new AI product may have barely any revenue, but enormous potential. Whether it becomes a billion-dollar business or nothing at all is unknown to any of the parties involved at the moment of sale.

Without an earn-out, one side would have to bear the entire risk. If the buyer pays the high price and the company disappoints, he has burned money. If the seller accepts the low price and the company booms, he has sold below value. The earn-out splits this risk. Both sides bet on the same outcome, and reality decides later.

There is also a second reason. Often the seller is also the founder, and his knowledge is a substantial part of the value. The earn-out ties him in: he only gets his full money if he stays for a few more years and keeps the business running. This is a strong incentive not to disappear with the money right after the sale.

Targets, deadlines, and the pitfalls of the benchmark

The purchase agreement states exactly what the additional payment is measured against. Common metrics are revenue, profit, or the number of paying customers. Sometimes there are also non-financial milestones, such as the approval of a drug or the launch of a product. On top of that comes a time period, usually one to three years after the sale.

The payout can occur in stages. One example: if the company reaches 50 million in revenue, there is an extra 10 million. At 70 million in revenue, it’s an extra 25 million. Often a cap is also set, so the buyer knows the maximum he can expect. The additional payment is made in cash or in shares of the buyer.

The catch lies in control. After the sale, the company belongs to the buyer, and he decides how it is run. He could cut the marketing budget or fold the company into a corporate division. Then revenue drops, and the seller doesn’t get his additional payment. That’s why good contracts include protective clauses that prohibit the buyer from making such interventions during the earn-out period. Nevertheless, earn-outs are among the most common triggers of disputes after a company acquisition.

Where earn-outs show up in acquisition announcements

In news about company acquisitions, you often read phrasing like: The purchase price is 200 million euros, plus up to 100 million in performance-based payments. This second part is the earn-out. It’s important to understand that the total sum mentioned is only an upper limit, not a guaranteed amount. Often, considerably less ends up being paid in the end.

Earn-outs are particularly common in the technology and pharmaceutical industries, where value depends heavily on uncertain future prospects. They are also standard in acquisitions of small AI companies by large corporations. When buying an established industrial business with stable figures, on the other hand, they are rarely needed – there the value is easier to determine.

The earn-out should not be confused with a holdback, known as an escrow. With an escrow, part of the purchase price is parked in a trust account as security against hidden defects such as legacy liabilities or legal disputes. This money already belongs to the seller in principle. The earn-out, by contrast, still has to be earned.